Bank regulation: ‘Basel IV’ sparks banker fury

The Basel Committee on Banking Supervision’s (BCBS) proposals to restrict banks’ use of internal models to determine their capital requirements and to limit their freedom to measure risk threatens to play havoc with banks’ capital planning and risk management.

Combined, the proposals represent a watershed in the Basel agenda to micro-manage risk, with some already calling this Basel IV. Not for attribution, bankers criticize it as an over-zealous and misguided bid to promote standardization that reveals more about the serial failures of bank regulators than about banks’ inadequate risk modelling.

In mid-December, the financial industry was caught off-guard by two Basel consultation papers from the BCBS addressing long-standing fears over the quality and comparability of risk-weighted capital ratios. It prescribes new metrics that would severely constrain the profitability of certain loan portfolios by hiking and shifting the composition of risk-weights.

As Basel III was an admission that Basel II got things wrong, Basel IV is a clear recognition that there is much that is wrong with Basel III Wayne Abernathy, American Bankers Association

Two papers

The first paper seeks to deter banks from reducing their capital requirements by tweaking internal models with the introduction of an unspecified capital floor, meaning capital requirements could not fall below a certain percentage compared to the standardized approach.

The second document aims to reduce reliance on external credit ratings and boost the risk sensitivity of banks’ exposures. The latter proposals are now relevant for all banks, since the revised standardized approach will be used to calculate a new capital floor for lenders that deploy an internal-ratings-based (IRB) approach to quantify capital for credit risk.

This proposed hardening of rules undermines policymakers’ promise to simplify regulation and G20 declarations last November that the key chapter in the Basel agenda – the system for regulating bank-capital – was drawing to a close.

Consultation on the two topics, on the bank-capital regime and standardizing credit-risks, is now drawing to a close. There is no target date for implementation and bankers hope the proposals will change beyond recognition before the final-rule stage. But the stakes are high. Wayne Abernathy, executive vice-president for financial institutions policy and regulatory affairs at the American Bankers Association, says the game-changing proposals, in effect, herald a shift to Basel IV, given the overhaul of the risk-weighted asset (RWA) regime.

“As Basel III was an admission that Basel II got things wrong, Basel IV is a clear recognition that there is much that is wrong with Basel III,” he says. “Yet the folks at Basel have not yet looked in the mirror and asked whether what is mostly wrong might be happening in Basel, that the simple concept of Basel I, to have some basic global capital standards, has been lost in an effort to over-engineer and micromanage at the global level the fine details of capital standards.”

The BCBS says the calibration of the capital floor will be unveiled at the end of the review process, expected at the end of this year, so it’s not possible to calculate its specific impact. However, European lenders are, in theory, most likely to see their internal models hit because of their relatively low ratio of RWAs as a proportion of gross total assets, reflecting their greater supervisory freedom to pursue the IRB approach given the diversity of universal banks’ business models in the EU.

Supporters

The new approach has its supporters, however. Alem Husain, European banks analyst at SNL Financial, says: “The introduction of capital floors and [proposals] to reduce the reliance on external credit ratings via the concept of ‘risk-drivers’ is far more intuitive and will be a significant shift in how banks and market participants assess RWAs and capital ratios. The proposed changes would also increase and validate the comparability of capital and capital ratios across banks.”

A Basel study in 2013 revealed risk-weightings for similar assets varied between banks by as much as 20%. As banks need to hold equity capital against RWAs, some market participants claimed that the differing approaches to risk-weighting were a form of regulatory arbitrage, often in favour of European lenders. However, that Basel study concluded on a sanguine note, arguing differing supervisory processes and legitimate differences of opinion on credit risk largely accounted for the divergence.

As a result, bankers are furious that Basel is now proposing to reduce their flexibility in quantifying credit risks.

BCBS wants to end the practice of risk-weighting lenders’ exposures by reference to external credit ratings and instead suggests using measures such as capital adequacy and asset-quality metrics on exposures to other banks, for example. For corporates, the BCBS argues a given borrower’s revenue and leverage should determine credit risk weights rather than ratings, with the latter typically discriminating between industries and local-accounting standards.

Bankers see plenty of problems. Since this way of risk-weighting exposure to other banks is determined by common tangible equity ratios and the non-performing assets ratio, it does not adequately take into account divergent liquidity and business-risk profiles, nor differences in supervisory processes under Pillar 2 of the Basel regime, says a senior regulatory adviser to the CEO of a large European universal bank.

The adviser adds: “Credit rating agencies look at a multitude of factors and these metrics are always richer, incorporating thorough timely reviews, and engagement with counterparties and agencies. You can also never empirically replace these qualitative assessments.”

Though the BCBS says the goal is not to hike overall capital requirements – and unrated corporates might, in relative terms, benefit from the new metrics – it is likely to constrain the profitability of certain loan assets. For example, the risk-weighting attached to corporates will jump from 30%-150% to 60%-300%. Meanwhile, the proposed risk weights for mortgages is in the 25%-100% range, compared with a flat 35% currently, based on the loan-to-value (LTV) ratio and a borrower’s indebtedness.

Dynamite

At present, some large IRB banks deploy a 16% risk-weighting to mortgage books, incorporating the divergent insurance and covenant regimes around the world that affect the probability of defaults. In addition, commercial real-estate would attract higher capital charges akin to unsecured loans. As a result, the proposals are political dynamite and threaten sacred cows to national banking systems, from small German banks to large mortgage lenders.

BCBS could also unwittingly promote the volatility of RWAs, since the proposed risk drivers are typically more pro-cyclical than credit ratings, while new proposed risk weights range between 0% and 400% compared to the current range of 0%-250%.

After lenders have spent hundreds of millions of dollars on bolstering systems to pursue an IRB model, the extent of capital relief provided by the latter is now patently unclear, bedevilling capital planning for banks and even strategic business planning. Capital planning is already challenged by a lack of clarity as to whether the leverage ratio or the risk-weighted capital regime will be the binding constraint for banks’ regulatory capital levels.

Bankers say the BCBS’s mooted end-of-2015 target for greater clarity on the new calibration of risk weights in the standardized model and the capital floor for the IRB is unrealistic, since it first needs to conduct a quantitative impact study based on end-of-2014 data. Many lenders are currently unable to provide this on a sufficiently granular and systematic basis.

But senior bank sources involved in discussions with Basel tell Euromoney that it is unclear to what extent their warnings over the pro-cyclicality of proposed risk drivers, and the dangers of a one-size-fits-all rating system will be heeded. One concludes: “Basel’s new mantra has been ‘finding the right balance between simplicity, comparability and risk sensitivity’. But with these proposals, the former has been sacrificed. While we expect some rebalancing in the final proposals – in favour of greater autonomy in internal models – no-one knows how the discussions will end up.”

The hope, at least, is that offers to increase the transparency and granularity of data, back-test models, harmonize some risk-weights on contentious portfolios and ensure cross-border supervisory cooperation, will be enough to ensure regulatory forbearance once the rules are finalized. In any case, Alem at SNL Financial expects operational costs for banks to increase, citing changes to IT systems and risk-processes.